## Understanding Price-to-Earnings Ratio from Scratch: An Essential Tool for Stock Market Valuation

If you've just entered the world of stock investing, the term "Price-to-Earnings Ratio" (PE) is certainly familiar. Investment advisors often mention a company's past PE ratio and current stock price to assess whether a stock is reasonably valued. But what exactly does the PE ratio represent, and why is it so important? This article will guide you to a deep understanding.

## Core Definition of the PE Ratio

**Price-to-Earnings Ratio (abbreviated PE or PER in English, full name: Price-to-Earning Ratio)** is a key indicator for measuring stock valuation. Essentially, the PE ratio reflects how long it takes for an investor to recover their investment through the company's profits.

For example: If TSMC's current PE ratio is about 13, it means the company needs 13 years of net profit to accumulate to its current market value. In other words, an investor buying the stock at the current price would need 13 years to recover their principal through dividends and growth. Simply put, the PE ratio helps us determine whether a stock is overvalued or undervalued at present.

## How to Calculate the PE Ratio

There are two main methods: one is dividing the stock price by earnings per share (EPS), and the other is dividing the company's total market capitalization by net profit attributable to common shareholders. In daily practice, the first method is more commonly used.

The specific calculation is: **PE Ratio = Stock Price ÷ Earnings Per Share**

For example, with TSMC, assuming the current stock price is NT$520 and the EPS for 2022 is NT$39.2, then PE = 520 ÷ 39.2 = 13.3. This number indicates that, based on current profitability, it takes about 13.3 years to break even.

## Classification of PE Ratios

Depending on the data source used for earnings, PE ratios can be divided into two main categories: "Historical PE" based on past data and "Forecasted PE" based on future projections. Among these, historical PE is further subdivided into two types.

### Static Price-to-Earnings Ratio:

**Calculation formula: PE = Stock Price ÷ Annual EPS**

Static PE uses data from the past year’s EPS. This data is usually published when the company releases its annual financial report, or can be calculated by summing the four quarterly EPS. For TSMC, the 2022 EPS is the sum of quarterly EPS: 7.82 + 9.14 + 10.83 + 11.41 = NT$39.2.

Since the annual EPS remains unchanged before the new annual report is released, fluctuations in the PE ratio mainly come from stock price movements. This is why it is called "static."

### Rolling Price-to-Earnings Ratio:

**Also known as TTM (Trailing Twelve Months), calculated as: PE(TTM) = Stock Price ÷ Sum of latest 4 quarters EPS**

Because listed companies release quarterly reports, the rolling PE reflects the cumulative profit over the most recent 12 months (4 quarters). Compared to static PE, it provides a more timely reflection of the company's earnings changes.

For example, if TSMC reports Q1 2023 EPS of NT$5, the latest 4-quarter total becomes: 22Q2(9.14) + 22Q3(10.83) + 22Q4(11.41) + 23Q1(5) = NT$36.38. The rolling PE then is 520 ÷ 36.38 ≈ 14.3, while the static PE remains at 13.3, showing a difference.

### Dynamic Price-to-Earnings Ratio:

Forecasted PE (dynamic PE) is based on predictions of future earnings. **Calculation: PE = Stock Price ÷ Estimated Annual EPS**

For example, if an investment research firm forecasts TSMC’s 2023 EPS to be NT$35, then the dynamic PE = 520 ÷ 35 ≈ 14.9.

Note that different institutions’ estimates often vary, and forecasts can be overly optimistic or conservative. Therefore, this indicator has relatively weaker practical utility and can sometimes confuse investors.

To help remember, here is a summary of the characteristics of the three types of PE ratios:

| Category | Calculation Formula | Advantages | Disadvantages |
|------------|------------------------|--------------|----------------|
| Static PE | Stock Price / Annual EPS | Data is fixed, objective and reliable | Lagging, may not reflect latest conditions |
| Rolling PE | Stock Price / Latest 4 quarters EPS | Overcomes lag, updates timely | Cannot predict future trends |
| Dynamic PE | Stock Price / Forecasted EPS | Forward-looking, guides future investment | Accuracy is uncertain |

## How to Judge Whether a PE Ratio Is High or Low

When you see a PE ratio number, how do you determine if it’s reasonable? The industry generally uses two comparison methods.

### Horizontal Peer Comparison

PE ratios vary greatly across industries. According to market data, the PE ratio for the automotive industry can be as high as 98.3, while shipping is only 1.8. Comparing companies across such different industries makes no sense.

Therefore, effective comparison must be limited to companies within the same industry and similar business models. For example, TSMC can be compared with UMC, Powerchip, and other foundries. Currently, TSMC’s PE is about 13, which falls between UMC(8) and Powerchip(47), indicating it is not overly high.

### Vertical Historical Comparison

Comparing the current PE with the company’s historical PE over past years can help assess its relative valuation. If TSMC’s current PE is 13, lower than 90% of its past 5-year PE levels, it suggests the current valuation is relatively cheap.

Using visual tools like a PE flow chart, you can easily see where the stock price stands in its historical valuation—overvalued, reasonable, or undervalued.

## Practical Application of the PE Ratio

### The Power of PE Flow Charts

PE flow charts are intuitive valuation visualization tools, displaying multiple parallel lines on a stock price chart. Each line is based on the calculation: **Stock Price = EPS × PE**

The top line represents the stock price corresponding to the highest historical PE, while the bottom line corresponds to the lowest PE. The middle lines show price bands at different PE multiples.

When TSMC’s stock price falls between PE 13 and 14.8, it indicates the current price is in a relatively undervalued zone, often a good entry point. However, even if the valuation looks cheap, it does not guarantee future rises, as many factors influence stock prices beyond PE.

### The True Relationship Between PE and Stock Price Movements

Many investors mistakenly believe that a low PE ratio means the stock price will necessarily rise, and a high PE means it will fall. In reality, **there is no direct causal relationship between PE and stock price movements**.

Stocks with low PE may continue to decline due to poor performance, while high PE stocks may keep rising because the market is optimistic about their prospects. The market’s willingness to assign high valuations often stems from optimistic expectations of future growth. That’s why many tech stocks have PE ratios far above traditional industries but keep hitting new highs.

## Limitations and Cautions When Using the PE Ratio

Although the PE ratio is the most commonly used valuation indicator, it has obvious limitations.

**First, it ignores corporate debt.** The PE ratio only considers equity value and does not account for a company’s debt level. Two companies with the same PE may have vastly different risk profiles if one has high debt and the other has little. Companies with low debt usually enjoy higher stock premiums; comparing PE ratios alone can lead to misjudgments.

**Second, it’s hard to define what constitutes a high or low PE.** A high PE may be inflated by short-term poor performance, but the company’s fundamentals are sound; or it may be priced in advance due to market expectations of high future growth. Different industries and business cycles mean there’s no universal standard.

**Third, it cannot evaluate unprofitable companies.** Many startups and biotech firms have yet to turn a profit, making PE calculation impossible. In such cases, other valuation tools are needed.

## Comparing PE Ratio with Other Valuation Indicators

To comprehensively evaluate stock value, investors should consider multiple indicators:

| Indicator | Full Name | Calculation Method | Application Scenario |
|--------------|--------------|------------------------|------------------------|
| PE | Price-to-Earnings Ratio | Stock Price / EPS | Mature companies with stable earnings |
| PB | Price-to-Book Ratio | Stock Price / Book Value per Share | Cyclical industries |
| PS | Price-to-Sales Ratio | Stock Price / Revenue per Share | Unprofitable startups with revenue |

PE(PE) is mainly used for profitable, stable companies; PB(PB) suits cyclical industries, especially when PB < 1 indicating undervaluation; PS(PS) applies to companies with revenue but no profit yet.

## Practical Investment Use of the PE Ratio

Once you master the calculation and application of the PE ratio, you can more scientifically select investment targets. Combining peer comparison, historical data, and market expectations, you can build your own valuation framework. Remember, the PE ratio is just one of many reference indicators; final investment decisions should be based on comprehensive analysis of company fundamentals, industry trends, and market environment. Through continuous learning and practice, you will gradually develop your own investment strategy.